BUSINESS PRACTICES

Legal Identity

First, some stock things about corporations that you need to know. You have a “legal identity” as an individual person. So does a corporation. It is considered a separate legal entity and has a life of its own. That life is perpetual, unless the owners, also called “shareholders” vote to dissolve the corporation by going out of business.

The most important thing to know is that under certain circumstances, a corporation will protect the owner(s) from any personal liability from activities of the business. It can also provide certain tax advantages for you as the owner.

 

 Liability

Here’s how a corporation will insulate its owner(s) from personal liability. If a corporation leases office or studio space, leases or purchases an automobile, office furniture, supplies, a telephone system, a photo-copier, etc., and is unable to pay, it is generally the corporation’s problem (“liability”) and not yours. The owner’s personal assets are protected from the corporation’s creditors as long as the corporation is run properly and the obligations are not personally guaranteed (for example, personally co-signing a loan or other agreement in addition to signing on behalf of the corporation).

Chapter S

You may also find it less taxing to be in business by electing S corporation status. Becoming an S corporation eliminates your income from being taxed twice once on your business’ profits and once more on the salary your business pays you. Instead of paying income taxes directly to the IRS or state, an S corporation passes its profits or losses to the shareholder, who is usually taxed at a lower rate.

Despite these apparent advantages, check first with your accountant and/or lawyer to make sure S corporation status is best for your business.

                                                                                                                                                                       

Other Benifits

Some other benefits to incorporating are the employee benefit plans that are more readily available to corporations as compared to sole proprietors and partnerships. In addition, you may find it much easier to obtain loans and other financing. Venture capitalists, family and friends may be willing to help fund your business for a “piece of the action” (which can be done through the sale of the corporate stock).

 Forming a corporation can also be good for your health -- by allowing you to set up a medical reimbursement plan. In this way, your medical expenses can be completely covered by the corporation, and the corporation may take the deduction as a business expense. This avoids the problem with personal limitations on medical deductions for individuals filing Schedule A on their individual tax return. 

What exactly is an LLC

To best understand LLCs, one should understand what corporations and partnerships were intended to accomplish for their owners. An understanding of LLC’s comes from an understanding of the shortcomings of corporations and partnerships and how LLC’s fill the gap.

Corporations and Partnerships

Until LLC’s came on the scene, business owners had a choice of business entity that was generally limited to corporations or partnerships, involving a trade off between, on the one hand, limitations on the liability of the business owners for debts of and judgments against the business, and, on the other hand, tax savings through a single, rather than a double, tax on business income. The ideal would be both.

Corporations

A corporation, is formed by filing articles of incorporation with the Secretary of State and governed under by-laws, normally provides its shareholders with a shield against creditors (whether lenders, suppliers, or tort judgment creditors) of the corporation, unless the shield could be “pierced” or the shareholders give personal guarantees. Generally, therefore, regardless of the financial strength of the corporation, the assets of the shareholders not invested in the business cannot be attached by the corporation’s creditors (“Can they get my house?”). Yet there is a tax price to be paid for this protection: a regular or C corporation is subject to tax as a separate person, and the shareholders can receive distributions of only the earnings of the corporation reduced by the taxes paid by the corporation. Also, if the corporation operates at a net loss, the shareholders are not able to claim the loss on their own tax returns.

These shortcomings may be overcome, to some extent, in several ways. A closely held corporation might pay out all of its earnings to its shareholders as salary or rent, thereby leaving no corporate income to be taxed. However, corporate losses would still be trapped in the corporation. Alternatively, the shareholders might make an election with the IRS under Chapter S of the Internal Revenue Code of 1986 (to become an S corporation), thereby allowing the income and expenses of the corporation to be reported, but not taxed, at the corporate level, with the shareholders paying all of the tax themselves on the net income earned by the corporation (or claiming all of the corporation’s losses as their own).

 To qualify as an S corporation, the corporation must clear several tests. Only US citizens and resident aliens may be shareholders, the company cannot have more than 75 shareholders. Entities such as other corporations, partnerships, estates and trusts (except for special S trusts) cannot be shareholders. Preferred dividend distributions are prohibited.

Also, appreciated property might be subject to corporate tax when sold by certain S corporations. There is a tax, and there are overall limits on passive investment income of certain S corporations. Needless to say, this makes S corporations unavailable or unattractive in a wide variety of situations.

Thus, if a corporation were the preferred form of doing business, one could get limited liability and one level of tax if one qualified as an S corporation, or the shareholders must accept the cost of paying tax at the corporate level in a “C” corporation. (Having said this, one should not always conclude that C corporation status must be avoided. Under current law, with the corporate income tax rate typically lower than the corresponding personal income tax rates on similar income, profitable businesses planning to plow earnings back into the business as working capital rather than distribute these earnings might be better off as a C corporation.)

Partnerships

At the other end of the spectrum lie partnerships. In its most basic form, the general partnership, the income and losses of the partnership business flow through directly to the partners and are not subject to tax at the partnership level. However, all the partners are jointly and severally liable for the debts and judgments of the partnership.

Of course, limited partnerships are employed by many to retain these tax benefits but reduce the liability of the partners. Every limited partnership requires at least one general partner. This leaves at least one person with complete exposure for partnership debts and judgments. A common solution to this problem is to form a special purpose corporation to hold a small partnership interest as general partner. While this is the accepted way to do business, it is cumbersome. Also, business operators, rather than passive investors, cannot, as a practical matter, be limited partners. Therefore, those who run the business are exposed to unlimited liability even when the business is operated through a limited partnership.

Accordingly, if partnership is the preferred business vehicle, one is able to keep taxes down and limit liability with a limited partnership having a corporate general partner, at the cost of administrative complexity. And even then the liability limits are less than perfect for those active in operation of the business.

Limited Liability Companies

With LLC’s, a hybrid form of business entity is at hand. Under the Illinois LLC Act, the members (analogous to shareholders in corporations and partners in partnerships) are all shielded from the company‘s debts to the same extent as shareholders in a corporation. Managers have the same shield as directors in a corporation. Also, the Internal Revenue Service has ruled that a properly formed LLC will be treated as a partnership for tax purposes. On December 27, 1996, the IRS issued Check the Box regulations, permitting entities other than true corporations to elect voluntarily whether to be taxed as corporations, or partnerships. This has the effect of making LLC’s a safer, surer bet. The election form to be filed is 8832.

Thus, in the right circumstances, there is no longer a need to use a corporation or a limited partnership with a corporate general partner to provide liability protection and there is no need to live with the limitations of the S corporation in order to get federal income tax advantages. It should be noted that in Illinois the LLC will not have to pay state income tax, but will be subject to personal property replacement tax on its income, despite its tax transparency for federal tax purposes. Also, the filing fee at organization is $400, and the annual fee, paid with the annual report, is $200.

LLC Certificate and Operating Agreement

The limited liability company, a creature of state law, is one created by filing of Articles of Organization (similar to articles of incorporation) with the Secretary of State. However, the company is not governed through by-laws; instead is governed by an Operating Agreement. The Operating Agreement is closer in form to a partnership agreement or corporate by-laws plus a shareholders’ agreement. The Operating Agreement sets the rules governing the company (such as the rules for meetings, if any) as well as the rights and responsibilities of the members vis-a-vis the company and vis-a-vis each other. Thus, it states the members’ understanding of who is responsible for contributions to capital and how much, who is to receive distributions and how much, who is to be allocated the various tax attributes of the company such as profits, losses, gains and credits, and under what circumstance the company will dissolve, among others. The Operating Agreement is not filed with any state agency 

Evidence of LLC Interest

The ownership interests in LLC’s may be reflected in share certificates, but need not be, and usually are not. In fact it is not unusual for LLC interests to be stated as a percentage of the company’s capital as in a partnership.

Management of LLC

It is up to the members to define in the Operating Agreement how the LLC will be managed. In some cases, the members might vest virtually all control of the LLC in one or a few managers (analogous to the officers and directors of a corporation or the general (managing) partner in a limited partnership). In other cases, the members might want a more active hand in company policy and day-today management, in which case the Agreement will provide for appropriate regular and organic vote percentages of members in a variety of circumstances.

         Annual and Special Meetings

Depending on the management structure of the company, the Operating Agreement might require regular meetings, as do typical corporate by-laws, or the members might forego meetings altogether.

Dissolution of the LLC

The Operating Agreement will also set forth the events that cause dissolution of the company. For instance, there may be a requirement that it dissolve upon the death or bankruptcy of a member or of a manager, or after the passage of a number of years.

Transfers of LLC Interests

The members will also provide in the Operating Agreement the rules governing when LLC interests may be transferred and which aspects of these interests may be transferred. These rules might include a right of first refusal for the remaining members. The “economic rights” of the members’ interests might be freely transferable to an outsider, but the recipient of these rights might not he admitted as a full member, with full rights of LLC membership, unless admitted by an affirmative vote of all or a significant percentage of the remaining members.

Tax Reporting for LLC's

When tax time roles around, the LLC will file a partnership tax return with the federal government and any requisite state tax forms. If treated as a partnership for federal tax purposes, the LLC will provide each member a Schedule K-I.

In the context of estate planning, where family limited partnerships are now being used, LLC’s are providing an alternative outlet. Of particular interest in estate planning is the availability of “inside” basis adjustment due to step up in basis at death. Like a partnership, the basis of LLC assets themselves may be adjusted to reflect the step up in basis at death available for the decedent‘s share of the LLC assets. Finally, since outside creditors of LLC members typically can get only a garnishment (charging order) against that member’s economic, interest, LLC’s provide an excellent component in an asset protection plan.

Single Member LLC's

Illinois’ amended Limited Liability Company Act now permits single member

LLC’s. This feature offers some unique opportunities to the sole proprietor. The big difference is, the LLC is a recognized legal entity for purposes of state law. It provides a liability shield like a corporation, but with far less formality. There is no requirement for the election of Directors and Officers. No annual meetings need be held and no minutes need be prepared. In fact, the LLC act says, in so many words, “The failure of a limited liability company to observe the usual company formalities or requirements relating to the exercise of its company powers or management of its business is not a ground for imposing personal liability on the members or managers for liabilities of the company.

A single member LLC is what the Internal Revenue Service calls a “disregarded entity.” This means that for purposes of the IRS, the company is totally transparent. Not only does it pay no tax, but the company need not even file an income tax return. Although S Corporations “pass through” their income, they still have to file a tax return. Single member LLC’s instead report profit or loss on their owners’ tax return. An individual will report his business on Schedule C of his personal return just as any sole proprietor does.

The State of Illinois Department of Revenue follows the lead of the IRS, so no Illinois corporate or partnership return is required for single member LLC’s, either.

Sole proprietorships cause problems at the owner’s death. Ordinarily a probate court supervised proceeding is involved to wind up the business, pay bills, close out bank accounts and so forth. On the other hand, the ownership of a single member LLC can be placed in a living trust, totally avoiding probate, and permitting the trustee to continue or wind down the business after the owner’s death, without involvement of the probate court.

Although the cost of creating a single member LLC is higher, its lack of formality makes it far less expensive to keep up, annually, than a corporation.

                                                                                                                                                                            Potential Downsides

As potentially wonderful as corporate status can be, there are limitations and some “downsides.”

Certain businesses should be aware of the Professional Service Corporation Act. Anyone opening a personal service business which requires a license before being able to render that service is subject to this act. You’ll still have to obtain the necessary license, even if you form a corporation. This law also provides that a person who has acted negligently or wrongfully or is guilty of misconduct will not be protected as a corporation from malpractice.

Also, corporations have some periodic filings with the IRS and state tax departments that most individuals do not face. Your corporation will also have to file an annual report to the state (usually, in most states, this just a short form to fill out as well as a modest fee to pay).

 Once you decide to “go corporate,” the actual legal procedure is fairly simple. But you ought to hire a lawyer to handle it.

There’s a form to fill out (“Articles of Incorporation”) and a filing fee ($100.00 for small corporations  and $400.00 for an LLC, in Illinois) to the Secretary of State of Illinois. Assuming your application is acceptable, you’ll receive a Certificate of Incorporation back in the mail from the Secretary of State in few weeks. This certificate will need to be filed with the Recorder of Deeds in your county (with a modest filing fee).

In the meantime, your lawyer will be preparing your “corporate book.” This includes such things as your corporation’s bylaws, stock certificates, and documentation relating to shareholders’ and board of directors’ meetings. It sounds complicated, but it really isn’t.

Also, if you do elect S Corporation status, make sure that your attorney or accountant makes a timely filing of this election so that Internal Revenue Service deadlines are not missed.

 Your attorney or accountant should also apply for a Federal Employer Identification Number (FEIN). This will identify your business to the IRS.